Short Iron Butterfly Options Strategy
26 May 2017
Nilesh Jain
New Page 1
A Short Iron Butterfly strategy is implemented when an investor is
expecting very little or no movement in the underlying assets. The motive behind
initiating this strategy is to rightly predict the stock price till expiration and gain
from time value. It is a limited risk and a limited reward strategy, similar to Long
Call Butterfly strategy. A Short Iron Butterfly could also be considered as a
combination of Bear Call Spread and Bull Put Spread.
When to initiate a Short Iron Butterfly?
A Short Iron Butterfly spread is best to use when you expect the
underlying assets to trade in a narrow range as this strategy benefits from time decay
factor. Also, when the implied volatility of the underlying assets increases unexpectedly
and you expect volatility to come down, then you
can apply Short Iron Butterfly strategy.
How to construct a Short Iron Butterfly?
A Short Iron Butterfly can be created by selling 1 ATM call, buying 1
OTM call, selling 1 ATM put and buying 1 OTM put of the same underlying security with the
same expiry. Strike price can be customized as per the convenience of the trader; however,
the upper and lower strike must be equidistant from the middle strike.
Strategy

Sell 1 ATM Call, Buy 1 OTM Call, Sell 1
ATM Put and Buy 1 OTM Put

Market Outlook

Neutral on market direction &
Bearish on volatility

Motive

Earn from time value with limited risk

Upper Breakeven

Short Option (Middle) Strike price + Net Premium Received

Lower Breakeven

Short Option (Middle) Strike price  Net Premium Received

Risk

Limited

Reward

Limited to premium received

Margin required

Yes

Let’s try to understand with an example:
Nifty Current spot price (Rs)

9200

Sell 1 ATM Call of strike price (Rs)

9200

Premium received (Rs)

70

Buy 1 OTM Call of strike price (Rs)

9300

Premium paid (Rs)

30

Sell 1 ATM Put of strike price (Rs)

9200

Premium received (Rs)

105

Buy 1 OTM Put of strike price (Rs)

9100

Premium paid (Rs)

65

Upper breakeven

9280

Lower breakeven

9120

Lot Size

75

Net Premium Received (Rs)

80

Suppose Nifty is trading at 9200. An investor,
Mr. A thinks that Nifty will not rise or fall much by expiration, so he enters a Short Iron Butterfly by selling a 9200 call strike price at Rs 70, buying 9300 call for Rs 30 and
simultaneously selling 9200 put for Rs 105, buying 9100 put for Rs 65. The net premium received to initiate this trade is Rs 80, which is also the
maximum possible gain. This strategy is initiated with a neutral view on Nifty hence it
will give the maximum profit only when the underlying assets expire at middle strike. The maximum profit from
the above example would be Rs 6,000 (80*75). The maximum loss will also be limited to Rs
1,500 (20*75), if it breaks the upper and lower breakeven points. Another way by which this strategy can give profit is
when there is a decrease
in implied volatility.
For the ease of understanding, we did not take into account commission
charges. Following is the payoff chart and payoff schedule assuming different scenarios of
expiry.
The Payoff chart:
The Payoff Schedule:
On Expiry NIFTY closes
at

Net Payoff from 1 ITM
Call Bought (Rs) 9200

Net Payoff from 1 OTM
Call Sold (Rs) 9300

Net Payoff from 1 ATM
Put bought (Rs) 9200

Net Payoff from 1 OTM
Put sold (Rs.) 9100

Net Payoff (Rs)

8800

70

30

295

235

20

8900

70

30

195

135

20

9000

70

30

95

35

20

9100

70

30

5

65

20

9120

70

30

25

65

0

9200

70

30

105

65

80

9280

10

30

105

65

0

9300

30

30

105

65

20

9400

130

70

105

65

20

9500

230

170

105

65

20

9600

330

270

105

65

20

Impact of Options Greeks before expiry:
Delta: The net delta of a Short Iron Butterfly spread remains close
to zero if underlying assets remains at middle strike. Delta will move towards 1 if the
underlying assets expire above the higher strike price and Delta will move towards 1 if
the underlying assets expire below the lower strike price.
Vega: Short Iron Butterfly has a negative Vega. Therefore, one
should initiate Short Iron Butterfly spread when the
volatility is high and is expected to fall.
Theta: With the passage of time, if other factors remain the same,
Theta will have a positive impact on the strategy.
Gamma: This strategy will have a short Gamma position, so the
change in underline asset will have a negative impact on the strategy.
How to manage Risk?
A Short Iron Butterfly is exposed to limited risk compared to reward,
so carrying overnight position is advisable.
Analysis of Short Iron Butterfly strategy:
A Short Iron Butterfly spread is best to use when you are confident that an underlying security will not move significantly and will stay in a range.
Downside risk is limited to the net premium received, and upside reward is also limited
but higher than the risk involved. It provides a good reward to risk ratio.